Bair on ending “too-big-to-fail”

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FDIC Chairwoman Sheila Bair is right now testifying in front of the Senate Banking Committee on “establishing a framework for systemic risk regulation.” This is of course hugely important. How do we end “too-big-to-fail?” And how do we resolve failures that are so big they pose a systemic risk?

There’s so much valuable stuff in this testimony, readers should really see all of it. To help you get through all 30 pages, I’ve highlighted key passages and provided commentary (in pink italics…I didn’t choose pink, btw, Scribd just read my formatting that way!).

Bair clearly knows what’s wrong with the system, and she articulates it more clearly than any other policymaker in Washington. She really does want to put the screws to big banks in order to end too-big-to-fail. She would do so by establishing a Financial Services Oversight Council to, among other things “actively control” leverage. She would also beef up resolution authority so policymakers could wind down bloated behemoths like Citi.

Right now they can’t resolve anything. Regulators’ choice is between bankruptcy and taxpayer-funded life support. Bankruptcies don’t work with systemically important institutions. This we learned from Lehman. Taxpayer subsidies only allow failed companies to keep operating on the public dime. Neither is desirable.

My chief worry in what she’s proposing is that whoever ends up becoming the systemic risk regulator may not have the same cojones she does. Who’s to say they will actually put the screws to the firms being regulated?

If they don’t, its sheer presence may backfire, especially if–as she proposes–there’s an “insurance fund” backing its resolution authority. Private market players will then misinterpret the systemic risk regulator as an implicit government guarantee that protects them from risk. Exhibit A is OFHEO with Fannie and Freddie. Exhibit B is FDIC itself and its Deposit Insurance Fund. Investors and/or depositors in these federally-backed institutions take MORE risk that creates BIGGER systemic problems than if there was a credible possibility they’d eat their own losses.

All of this would be much easier if the Fed just exercised its authority over bank reserve requirements. Requiring banks to hold significantly more capital in reserve, and preventing them from hiding risk off their balance sheets, would solve just about every problem we face.

(For ease of reading, click on the top right button to toggle to full screen. If that doesn’t work, click on the link at the top to go directly to Scribd.)

Team that up with lowering the national deposit cap from 10% to, say, 3%. This would, of course, require the Ma Bell style break up of JPM, BAC, C, and WFC, and I’m sure we’d spend many days weeping. Wouldn’t techincally prevent a bank from getting so large as to be a systemic threat, but the bank would have to use much more actualy debt to do it, and that’s both more expensive to the bank and not FDIC insured.

As you say, “My chief worry in what she’s proposing is that whoever ends up becoming the systemic risk regulator may not have the same cojones she does”

When things get risky, it also means somebody, many, are making out like a bandit. These folks will be raking in the bucks, be willing to spread some around politically and will be busily networking with the rich and powerful in DC. The question posed for the regulator is whether to cut short the banditry with the associated disruption while not knowing when it would otherwise self-destruct if no action is taken, the old punch bowl that never seems to have been taken away. Greenspan was a god, remember?

So any pressure to act is offset by the uncertainty about what bad stuff will come and when. How often have we heard about there being no way to tell if you are in a bubble? More accurate is to say how to predict when the bubble will end is impossible. Bureaucracies, regulatory or otherwise, love to keep on keeping on with the status quo. How many times this behavior has been seen yet we keep coming up with the same inadequate scheme.

What really does the trick is very, very bad pain…the kind of 1930′s pain that alters the mindset of a generation. That is the most effective regulator because it is a policeman that sits in the minds of millions, often for the rest of their lives as it did with my parents.

Which is better for people to think:

“Jesus, that period of my life was hell. Never again will I touch (fill in the blank).”

[...] Chairwoman Sheila Bair testified in front of the Senate Banking Committee and detailed her plan on ending the “too big to fail” framework we currently have established for our banking industry. The need for financial oversight is [...]